Defined benefit pensions are the most secure and reliable way to provide retirement security for working families. The key feature of pensions is that they pay a guaranteed monthly benefit for life. This provides retirees with unparalleled retirement security and keeps retired public employees out of poverty. People often wonder though, how are those monthly pension benefits calculated?
Most defined benefit pension plans use a formula that calculates three factors: the number of years of service of the employee; the final average salary of the employee; and a benefit multiplier. The first of these is fairly straightforward: if you work for an employer for 30 years, then 30 is used as one of the factors in your benefit calculation.
Final average salary varies a little bit more from pension system to pension system. In many places, it is the average salary of the final three years of service that is used. In some places it is four or five years; rarely is it longer than that. In other systems, instead of using the final three years of salary, they use the three years of highest average salary (or four or five years).
The final factor used in pension benefits calculation is a benefit multiplier. This is a percentage, often ranging from 1% – 2.5%, that determines the size of the benefit amount. For example, if you had a public school teacher who earned a final salary of $40,000 per year and worked 25 years and had a 2 percent multiplier, than that teacher would earn a $20,000 per year pension benefit, the equivalent of half of their final salary.
The pension benefit formula is the key design feature of defined benefit pensions. The formula can be used to make pensions more or less generous. As such, it is important to understand what it does and how it works.